A Framework To Audit Intellectual
Capital

Indra Abeysekera, Dynamic Accounting

ABSTRACT:

Until recently few firms have attempted to measure and assess Knowledge, the
new intangible. Previous research shows that key components of intellectual
capital are poorly understood, inadequately identified, inefficiently managed
and inconsistently reported. Two types of audit are available: auditing by
competence, and auditing individual or a spectrum of items. There are several
methods for auditing these types, and selection depends both on the type of
audit, and whether the aim is to quantify monetarily, to make comparisons, or
to set benchmarks. A better way to approach the audit is to combine more than
one method and audit object, so that any limitations imposed by one are
compensated for by the other.

1.Introduction

Until recently few firms have attempted to measure and assess the new
intangible, knowledge (Guthrie and Petty, 2000 (a)). A study in Australia found
that key components of intellectual capital are poorly understood, inadequately
identified, inefficiently managed and inconsistently reported. The firms did
not have a consistent framework to report on intellectual capital (Guthrie,
1999; Guthrie, Petty, Ferrier, and Wells, 1999; Guthrie and Petty, 2000
(b)).As a response, the
frameworks to audit intellectual capital have emerged from a recent branch of
research in intellectual capital. The argument is based on that both financial
and non-financial data on intellectual capital should be consistently gathered
using a cohesive framework.

Intellectual capital audit is used in a wider context than a financial
audit. Firstly, its purpose is to monitor and oversee the intellectual capital
of a firm (Brooking, 1996, pp86) and secondly, an intellectual capital audit
requires a team comprising different experts, corporate strategists, finance
experts, human resource experts, knowledge analysts, intellectual property
experts and marketing experts (Brooking, 1996, pp93-95; Brooking and Motta,
1996). It is important to carry out an audit of intellectual capital items for
the following reasons (Brooking, 1996, pp83-85). Firstly, it is a rich source
of data that helps to fill the gaps in the strategy to make it successful.
Secondly, it helps to evaluate and design R&D programs. Thirdly, it
provides knowledge in re-engineering a firm to retain valuable capability and
know-how. Fourthly, it helps plan education and training programs mutually
beneficial to the employees and organization. Fifthly, it provides information
on assets not recorded in traditional accounting to ascertain the value of the
enterprise (Daveport and Prusak, 1998, pp85). Sixthly, it enables to ascertain
organizational memory and expand it so that organization does not have to
reinvent the wheel.

There are several steps to follow when undertaking an intellectual audit.
Firstly, the firm should determine the purpose of the audit whether to quantify
results monetarily, to set comparatives, or benchmarks. Secondly, identify the
problem space so that audit provide focus and is manageable. Thirdly, determine
the aspect of the asset to be investigated (for example on customer base; it
could be size, repeat business, customer profile or brand loyalty). Fourthly,
assign high values as a benchmark to the asset aspect been investigated (ex.
Repeat business, the high value is 100%), and fifthly, choose the audit method.
An audit can be carried out on individual intellectual items or on all
intellectual items using a framework. Ferrier (1999) points to appraising the
firm on the perceived awareness and importance of intellectual capital, through
‘an information and self-evaluation kit’ before carrying out an intellectual
audit.The ‘kit’ asks questions in
broader areas such as; what is intellectual capital? ; Why is it important? ;
Perceived status of intellectual capital in the firm in relation to other firms;
measuring of intellectual capital, and matter relating to reporting of
intellectual capital. This is because anecdotal evidence suggests that
measuring, reporting and managing of intellectual capital happens in an
individualistic and ad-hoc manner. The ‘information and self-evaluation kit’ is
still at an early development stage and can be viewed as a precursor to an
internal intellectual capital audit.

2.Types
of Audits

There are two major types of audits. One is to audit by core competencies,
and the other is to audit either individual or a spectrum of audit items.

2.1Auditing
core competencies

Auditing by core competencies is one way to audit intangible assets
(Andriessen, Frijlink, van Gisbergen, and Blom, 1999). First intangible assets
are defined in relation to core competencies of the firm. Each core competence
is a combination of intangible assets such as knowledge and skills, standards
and values, explicit know-how and technology, management processes and assets,
and endowments such as image, relationships, and networks. Knowledge creation is
the core competence of any firm (Malhotra, 2000). Secondly, the strength of
each core competence is estimated with the aid of a checklist using five
criteria. These criteria are, customer benefit, better than competition, future
potential, difficult to imitate, and solidly embedded. The checklist provides a
score from 0-5. Thirdly, the value of each core competence is determined in
relation to five value drivers, namely, added value, competitive advantage,
potential, sustainability and robustness.Fourthly is to monitor them. Once the value of intangible assets is
determined for a number of years they can be converted to an index and changes
can be explained in qualitative terms.This method of auditing core competencies has certain limitations. The
management time and commitment is a pre-condition. The firm should have a clear
strategy to increase the value of intangibles. The thinking in terms of core
competencies is easier for some organisations only (Andriessen, Frijlink, van
Gisbergen, and Blom, 1999).

2.1Auditing
individual or a spectrum of items

The second way involves auditing individual or a spectrum of items. Some
authors have attempted to assign a monetary value to individual intellectual
capital items. Measuring the monetary value of customers (Bursk, 1966) and
contract rights (Reilly and Dandekar, 1997) are examples. The monetary
measurement methods are suggested on several intellectual capital items. The
measurement method can be market approach, replacement cost approach, or income
approach (based on income producing capability of the asset) (Brooking, 1996,
pp181-182) depends on quantity and quality of data available, purpose and
objective of the exercise, and experience and judgement of the accountant
(Reilly and Dandekar, 1997).In
this respect, auditing patents seems to be an established area (Petrash, 1996;
Rivette and Kline, 2000). It could be because patents are the most tangible
intellectual property that has the strongest legal protection and has the
greatest effect on commercial success for certain organizations. They help
protect core technologies and business methods, boost R&D, increase
branding effectiveness, improve financial performance and enhance
competitiveness (Rivette and Kline, 2000).

To assess the financial value, many companies assign a portion of market
capitalization as a proxy of their intellectual property as an alternative to
individual patent measurement. Another method is to use knowledge scorecard.
Knowledge scorecard is the capitalized difference (net present value) between
annual normalized earnings and earnings from financial and physical assets
(Rivette and Kline, 2000). A primary consideration in the valuation is the
strength of protection (Brooking, 1996, pp183). The business and commercial
value of patents is ascertained by mapping patents as growth rate in the
vertical axis and their current and future use in the horizontal axis (Rivette
and Kline, 2000). Another way is visualise the firm’s patents along with any or
all competitor patents and evaluate such things as dominance, breadth of
coverage, blocking and opportunity openings (Petrash, 1996). Intellectual Asset
Managers through their Intellectual Asset Management Teams are responsible to
develop and maintain an intellectual asset plan to align with the business
strategy, and review intellectual asset portfolio at least once a year. They
are also responsible to identify key intellectual assets, classify them by
utlisation, manage portfolio costs, where appropriate do a competitive
technology and portfolio assessment, and create and staff intellectual assets
team and facilitate meetings. Further, they provide leadership and support to
the intellectual asset management vision and process implementation, and
recommend for licensing, abandonment, donation and utilization of intellectual
assets (Petrash, 1996).Some
companies tend to adopt measuring individual intellectual capital items as a
basis to develop a comprehensive capital measurement system. For example, Dow
Chemicals was developing its ‘patent tree’ into ‘knowledge tree’ to carry out
an intellectual asset audit that includes their biggest intellectual asset,
know how (Petrash, 1996).

Brooking (1996) proposed a framework with intellectual capital items
(Brooking, 1996, pp12-81, pp129; Brooking and Motta, 1996) to be used as a
basis to audit a spectrum of intellectual capital items. The framework was
expanded by later by other authors (Australian Society of CPAs and The Society
of Management Accountants of Canada, 1999, pp14; International Federation of
Accountants, 1998, pp7; Dzinkowski, 1999 (b); Dzinkowski, 2000). Guthrie et.al
(1999) further modified that framework to ascertain the status of intellectual
capital reporting in Australia. The framework was expanded further for a more
detailed analysis of human assets (Abeysekera, 2001) (refer to Appendix 1).

3.Research
Methods

There are several methods to carry out an internal intellectual capital
audit.Different research methods
may be more suitable for different intellectual capital items.

An external intellectual capital audit can be carried out using interview,
surveys, content analysis, focus groups and case studies are the most popular
method (Petty and Guthrie, 2000 (b)). This can be because case studies help
managers to generate actionable knowledge and they are very strong lessons for
the company (Eccles, Nohria and Berkley, 1992, pp180). Description of knowledge
is similar to description of story suggesting there is a meaningful link
between the two. By encoding knowledge in stories, little of the leveraged
value of knowledge is lost in communication (Davenport and Prusak, 1998,
pp81).Interviews and questionnaires
are used to supplement each other and used usually for larger sample sizes
(Petty and Guthrie, 2000 (b)).

Most of the examples cited in the knowledge management and intellectual
capital literature are based on case studies. Although case studies are one of
the best ways to understand and disseminate knowledge because narratives and
story telling is a very effective way to convey knowledge (Davenport and
Prusak, 1998, pp81). However, case studies are one of the weakest empirical
research methods in terms of validity and reliability (CASL, http://iisd.ca/casl/CASL
Guide/ParticipantObserver.htm, 1998).

Since knowledge management and intellectual capital are about intellectual
assets and liabilities, accurately measuring them in verifiable manner has not
been perfected yet.It is also
difficult to carry out quantitative research such as laboratory-based
experiments to establish relationships of individual intellectual capital
variables to results since there are other intervening and moderating variables
that confound the results. The relationship of those other variables is also
not established. One way to restore the empirical validity and reliability is
to carry out carefully planned qualitative research. There are several
established instruments such as content analysis, field studies, focus groups
and case study interviews.It is
necessary to reinforce these single methods with one or more other methods to
enhance validity and reliability. Such empirical research approach is necessary
to restore credibility and verifiability of results in the minds of the
educated reader.

4.Audit
Objects

The object to be audited can be broadly classified into an examination of
documentary evidence in both written and other forms, the processes and values
of the firm, and aspects of employees and their relations with others (both
people and institutions). The object used to audit intellectual capital
determines the research methods to be employed (refer to Figure 1) and some
research methods are more suitable to examine a given audit object than others.

The documentary evidence of intellectual property is legally binding, and
minutes of management and board meetings reveal the status and strategic
direction the firm. Company annual reports are also useful audit objects as
they enable organisations to construct relationships with others to create and
maintain conditions for their continued profitability and growth (Niemark,
1995, pp100). It is not the only weapon available to do that. Advertising,
sales promotion, public relations campaigns, political lobbying, charitable
contributions and support for scientific research and so forth are more
important weapons. However, annual report represents the corporate concern in a
comprehensive and compact manner. Further they are regularly produced and offer
a summary of management’s thoughts in each period (Niemark, 1995, pp100-101).
The purpose of annual reports can be defined as ‘demonstrating present and
future performance’. Annual reports is a special communication opportunity to
go beyond reporting simply financials and is a chance to show leadership and
vision to reflect organisation’s value and its position (Clackworthy,
2000).Annual reports are a good
proxy to audit comparative position and trends of intellectual capital between
firms, industry and countries. Several published research have used annual
reports as audit objects to ascertain the status of intellectual capital of
firms in Australia Australia (Guthrie, 1999; Guthrie, Petty, Ferrier, and
Wells, 1999) and Ireland (Brennan, 1999), and between countries (Subbarao and
Zeghal, 1997).

5.Conclusion

The type of audit to be carried out is governed by factors such as time and
commitment of the management to the audit. Although there are several research methods
available to audit intellectual capital items, some methods are better than
others for auditing a given intellectual capital item.It also depends on the level of
validity of the findings required and the purpose of the audit. If the purpose
is to quantify them, then a high internal validity method may be more suitable,
and if the purpose is to set benchmarks then a high external validity method
may be more suitable.The type of
audit object to be examined is determined by the access to information, time
available for the audit, and the level of validity required from the
audit.A better way to approach
the audit is to combine two or more methods of auditing and audit objects so
that any limitation imposed by one method and object are compensated by the
other. However, any audit on intellectual capital of a firm is better than no
audit since it is one of the most important assets that needs to be managed
consistently and efficiently to harness its value to increase the bottom line.

Brooking, A. (1996) Intellectual Capital, Core Assets for the Third
Millenium Enterprise, International Thomson Business Press, London

Australian Society of CPAs and The Society of Management Accountants of
Canada (1999) “Knowledge Management: Issues, Practice and Innovation”,
Australian Society of Certified Practising Accountants, Melbourne

Guthrie, J., Petty, R., Ferrier, F. and Wells, R. (1999) “There is no
Accounting for Intellectual Capital in Australia: A review of annual reporting
practices and the internal measurement of Intangibles”, OECD Symposium on
Measuring and Reporting of Intellectual Capital, Amsterdam, June 9-11

International Federation of Accountants (IFAC) (1998) “The Measurement and
Management of Intellectual Capital: An Introduction Study”, October, IFAC, New
York

Indra Abeysekera received his B.Sc degree from University of Peradeniya, Sri
Lanka, Master of Science degree from University of Wales, U.K., and Master of Commerce
degree from Macquarie Univeristy, Sydney, Australia. Indra is a Chartered
Mangement Accountant in the U.K. and a CPA in Australia. He also lectured at
The University of Sydney. Presently, he is Director, Dynamic Accounting, a
Sydney based accounting and business consulting firm in Australia. He can be
reached at: 5/5 Doomben Avenue, Eastwood NSW 2122, Australia; Tel: +61 417 405
399; Email: iabeysek@hotmail.com